June 5, 2017

Monday Morning Memo: Are innovative products a call for more research efforts?

by Detlef Glow

Looking at the newly launched funds in Europe, I have come to realize that there seems to be a general trend toward more flexibility in the funds. A high number of funds launched over the last three years have extended investment objectives. That is true not only for the new generation of mixed-asset products but also for so-called multi-asset funds, where fund managers can invest not only in cash, bonds, and stocks but also in commodities, properties, and short positions as well as other derivative strategies to generate returns. More and more equity funds and bond funds have wider investment universes to enable them to harvest returns from different sources, including short positions.

For bond funds this seems to be a logical reaction to the current low-interest-rate environment, since the only way fund managers of government bond funds can generate returns in a scenario of rising rates is to use short positions. On the other hand, managers of total-return portfolios have the opportunity to protect their portfolio with a broad diversification that includes using corporate and high-yield bonds. For these managers short positions are just another source of return, so they might use their flexibility here as well.

Within the equity space it is not so common for portfolio managers to have the ability to use short positions in their portfolios; nevertheless, the number of long/short funds and equity funds with an extended management approach has risen.

Not only have mutual funds seen increased launch activity with regard to “plain-vanilla” funds. In the exchange-traded funds (ETFs) segment this trend has become even more obvious; factor investing—the so-called smart beta approach—has become very popular with European investors. Factor investing means the weightings of the constituents within the indices, which are the basis for each ETF, are not weighted by their market capitalization. Instead, they are weighted with regard to their exposure to the factor that will be exploited by the ETF. The most used factors are size, minimum volatility, quality, and value. Since the ETF industry is very innovative, it is not surprising that we are seeing the launch of a high number of factor-based ETFs; while the majority of plain-vanilla indices are already covered and promoters are in a kind of price war, the factor-investing ETFs segment offers a lot of opportunity for new market entries as well as for existing fund promoters to gain market share.

All in all, it can be said that the variety of new products increases the complexity of the market and raises new issues for investors, since funds with extended investment objectives are much harder to evaluate from a qualitative perspective, i.e., a short position needs to be managed very differently compared to a long position. This means the fund manager needs to have a totally different skill set, and the management company needs to have risk management systems in place to properly evaluate the risk of short positions. The same is true for factor indices and multi-asset portfolios, where managers may enter new territory for themselves as well as for their investors.

In light of this complexity, private investors may need the help of a qualified advisor to make an educated decision about which fund they should use in their portfolio. In a market environment such as Europe where the number of advisors serving retail clients is shrinking, it may become harder for the average investor to find the advice needed to build a portfolio that fits a particular risk profile and investment need.

The views expressed are the views of the author, not necessarily those of Thomson Reuters.

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